Keynes and Wicksell

Keynes first took up Wicksell’s idea in his Treatise on Money (1930). In Wicksell’s writings, discrepancies between the natural and market rates had invariably been associated with expansion or contraction of bank credit. Keynes emphasized that such discrepancies may develop and continue without expansion or contraction of the money supply, because of speculation in the securities markets. For example, if the natural rate has decreased and the market rate starts to edge down in response to an excess of the household savings offered in demand for securities over the supply of new securities marketed to finance investment, securities prices will rise. This, Keynes suggested, will cause some speculators in “old” securities to enter the market and supply savers with securities from their holdings. The excess demand pressure on the market is thus relieved and the rise in prices (fall of the market rate) halted. The motive for these transactions is the speculators’ hope that they can buy back their securities at lower prices later. In the meantime, the speculators hold their funds in the form of ready money; there has been an increase in the amount of money demanded rather than, as Wicksell assumed, a decrease in the money supply.

The Wicksell–Keynes theory was an important contribution to the theory of the income-determination process. Yet there is nothing in its main elements that should have startled a pre-Wicksellian traditional economist. The natural rate is essentially the interest rate that would prevail in general equilibrium, and a market rate different from the natural rate is a disequilibrium interest rate. Traditional economics was clear enough as to the consequences that will follow if one or more of the prices in the system “gets stuck” at a disequilibrium level. The Wicksell–Keynes theory, therefore, may be regarded as a particular application of previously familiar principles.

Keynes returned to the Wicksellian theme in The General Theory of Employment, Interest and Money (1936), but in that revolutionary work he gave the theory a genuinely novel twist: he argued that the system might be seriously out of equilibrium even though the prevailing interest rate was exactly at the Wicksellian natural level. This might happen because the interest rate mechanism cannot ensure that the plans of households and business firms with regard to future consumption and production will mesh with each other. There might, for example, be an increase in household saving—that is, a decrease in the demand for current consumption goods and an increase in the planned demand for future goods. Coordination of household and business activities requires that business firms respond by shifting resources out of the production of present consumption goods and into investment activities that lay the groundwork for increased output in the future. Households, in carrying out their saving decisions, do not place contractual orders with producers for future deliveries of particular goods and services. Thus, the future demands implicit in current saving decisions may not be effectively communicated to producers, as efficient coordination would require. If producers draw up their investment plans on the basis of forecasts of future demand that do not correspond to the spending that households are prepared to undertake in the future, there will be an excess demand (or excess supply) for future output.

Such effective demand failure is not the result of changes in interest rates or in the supply of money. The logical way of dealing with it—when it occurs—is through fiscal policy measures. The effective demand doctrine is the signal contribution of Keynesian economics to income and employment theory. It is thus no coincidence that Keynesian economics has become associated with an emphasis on the use of fiscal, rather than monetary, stabilization policies.